Monetary Transmission in Developing Countries: Evidence from India

Abstract

There are strong priori reasons to believe that monetary transmission may be weaker and less reliable in low- than in high-income countries. This is as true in India as it is elsewhere. While its floating exchange rate gives the RBI monetary autonomy, the country’s limited degree of integration with world financial markets and RBI’s interventions in the foreign exchange markets limit the strength of the exchange rate channel of monetary transmission. The country lacks large and liquid secondary markets for debt instruments, as well as a well-functioning stock market. This means that monetary policy effects on aggregate demand would tend to operate primarily through the bank lending channel. Yet the formal banking sector is small, and does not intermediate for a large share of the economy. Moreover, there is evidence that not only are the costs of financial intermediation high but also that the banking system may not be very competitive. The presence of all these factors should tend to weaken the process of monetary transmission in India. This paper examines what the empirical evidence has to say about the strength of monetary transmission in India, using the structural vector autoregression (SVAR) methods that have been applied broadly to investigate this issue in many countries, including high-, middle-, and low-income ones. We estimate a monthly VAR with data from April 2001 to December 2014. Applying a variety of methods to identify exogenous movements in the policy rate in the data, we find consistently that positive shocks to the policy rate result in statistically significant effects (at least at confidence levels typically used in such applications) on the bank lending rate in the direction predicted by theory. Specifically, a tightening of monetary policy is associated with an increase in bank lending rates, consistent with evidence for the first stage of transmission in the bank lending channel. While pass-through from the policy rate to bank lending rates is in the right (theoretically expected) direction, the pass-through is incomplete. When the monetary policy variable is ordered first, effects on the real effective exchange rate are also in the theoretically expected direction on impact, but are extremely weak and not statistically significant, even at the 90 % confidence level, for any of the four monetary policy variants that we investigate. Finally, we are unable to uncover evidence for any effect of monetary policy shocks on aggregate demand, as recorded either in the industrial production (IIP) gap or the inflation rate. None of these effects are estimated with strong precision, which may reflect either instability in monetary transmission or the limitations of the empirical methodology. Overall, the empirical tests yield a mixed message on the effectiveness of monetary policy in India, but perhaps one that is more favorable than is typical of many countries at similar income levels.

Estimates the pass-through from monetary policy changes to bank interest rates in two steps

(i) from the monetary policy rate to the interbank market rate (that is the operating target of the framework)

(ii) from the target rate to bank interest rates (deposit and lending rates)

Daily data on interest rates and LAF transactions are averaged over 2 week periods, and the bank balance sheet data is available on a bi-weekly basis

The monetary policy rates considered are the reverse repo rate and the repo rate

Market interest rate targeted by the monetary policy framework is the weighted average call money rate and the two main bank interest rates considered are the rate on 3-month certificates of deposits and the prime lending rate (the average of five major banks)

Although banks now price loans from the base rate, they still report PLRs. In practice, the prime lending rate and base rate of banks move together

Significant, albeit slow, pass-through of policy rate changes to bank interest rates in India. The extent of pass-through to the deposit rate is larger than that to the lending rate, and the deposit rate adjusts more quickly to changes in the policy rate

Evidence of asymmetric adjustment to monetary policy: the lending rate adjusts more quickly to monetary tightening than to loosening.

Deposit rates do not adjust upwards in response to monetary tightening, but do adjust downwards to loosening

The speed of adjustment of both deposit and lending rates to changes in the policy rate has increased in recent years

“Changes in Transmission Channels of Monetary Policy in India,” Economic and Political Weekly

Monthly data

April 1993 to March 2012

VAR

Introduction of LAF as an operating procedure for monetary policy in the post-reform period is a landmark event for monetary policy. This paper looks for a structural break in the post-reform period corresponding to the introduction of LAF in 2000

Assesses the changing importance of various transmission channels of monetary policy in the pre-LAF and post-LAF periods

Divides sample into two periods—pre-LAF (before 2000) and post-LAF (post 2000) and sees whether the transmission has changed in the transition

Finds a structural break in transmission corresponding to the introduction of LAF in 2000

Bank lending channel remains an important means of transmission of monetary policy in India, but it has weakened in the post-LAF period

The interest rate and asset price channels have become stronger and the exchange rate channel, although weak, shows a mild improvement in the post-LAF period

Interest rate channel—Hike in policy rate leads to a decline in GDP growth on impact (magnitude: 0 to –0.0015) that dissipates slowly showing a V-shaped response whereas WPI inflation on impact goes up (0–0.0008), declines in about two quarters (to –0.0018) and its peak impact is felt with a lag of one quarter from the corresponding peak impact on GDP growth

Credit channel—Shock to interest rate leads to decline in credit growth from 2nd quarter; GDP growth also declines on impact and negative impact on inflation (which goes up on impact) occurs one qrtr after the GDP decline

Asset price channel—Equity price index goes up on impact and declines in second qrtr, GDP growth declines on impact and peaks in second quarter, and impact on inflation (goes up on impact) is more muted relative to other two channels

Exchange rate channel—Immediate REER appreciation followed by depreciation; GDP response is very little and inflation shows a negative impact

Summary: Inclusion of external variables prolongs the impact of MP shocks on GDP growth and inflation. Interest rate, asset price and credit channel are important while exchange rate channel is weak. Interest rate channel accounts for about half of the total impact of monetary shock to GDP growth and about one third of total impact on inflation, indicating it is the most important channel in India

“Evidence on interest rate channel of monetary policy transmission in India,” paper presented at the Second International Research

Conference at the Reserve Bank of India

Quarterly data (Paper not found)

Structural VAR

Interest rate channel

Studies policy rate changes through to their effects on output and inflation

Provides evidence that policy rate increases have a negative effect on output growth with a lag of two quarters and a moderating impact on inflation with a lag of three quarters, with both effects persisting for eight to ten quarters

Results underline the importance of interest rate as a potent monetary policy tool

Examining the impact of changes in policy rates on lending rates and deposit rates of commercial banks

Panel framework of seven EMEs including India

Examined the transmission of policy rate viz., repo rate from the perspective of demand for bank credit in India.

Monetary Policy Variable: Repo rate

Change in policy interest rate is an important determinant of firm’s demand for bank credit (Not giving more details as this is more focused on a specific pass-through rather than complete transmission to real variables)

Ordering Rationale: They argue that RBI takes into account current stage of GDP and prices. Thus, overnight call money rate responds contemporaneously to shocks to GDP and prices. However, GDP and prices do not respond contemporaneously to overnight call money rate shocks. Likewise GDP, prices and overnight call money rate do not respond contemporaneously to a shock to the transmission channel specific variable but the reverse holds.

Model 3: Then exogenizes latter using its lags as exogenous variables and compared (2) and (3) IRFs. (Mostly looking at GDP response)

Do not have confidence interval bands around IRFs. They do these as robustness checks, estimating ±2S.E confidence intervals after blocking off each channel by exogenizing it

Results from Model 1

An increase in call money rate leads to a decline in GDP which bottoms out in third quarter and shows a V-shaped response. Prices also decline in response to a positive overnight call money rate shock and recovers after third quarter. Prices start declining after the fall in GDP (same as previous study). This effect disappears when exogenous variables are added. And monetary policy shock has temporary effects on the call money rate. Results from Model 2

Bank Lending channel—Prime lending rate responds immediately to a call money rate shock. A positive shock creates an initial increase in PLR to 0.24 %. After the second quarter, it converges toward the baseline.

With bank loans, quantity of bank loans to the commercial sector decreases initially in response to a monetary policy tightening and then recovers after third quarter. Prices and GDP show a similar decline, bottoming out in third quarter

Exchange rate channel: REER initially appreciates and shows a short-lived reaction to a positive overnight call money rate shock. GDP response is also very weak. Prices decline and show a V-shaped response.

Summary

Imposed restrictions on contemporaneous effects of endogenous variables to have an exact identification of benchmark VAR model

1. The results of the benchmark VAR model suggest that a monetary policy shock has transitory effects on call money rate. The price-puzzle vanished after inclusion of vector of exogenous foreign variables. Prices and GDP decline after a positive call money rate shock. Moreover, prices start declining after a decline in GDP

2. Results support the importance of bank lending channel in transmission of monetary policy shocks to real sector

4. Inclusion of foreign exogenous vars reveals that Indian monetary policy is constrained by US Fed’s monetary policy. Hence, an analysis of Indian monetary policy requires inclusion of the federal funds rate in the information set of RBI

5. A proper comprehension of monetary transmission mechanism in India requires analysis not only of response of GDP, but also of response of exchange rate to monetary policy shock

6. Banks play an important role in financial intermediation in the Indian economy, and their strong representation reflects the lack of alternative sources of funding for the private sector

Unified treatment of exchange rate pass-through and the monetary policy transmission—assessment of the effectiveness of two alternative paths through which changes in the short rate impact upon the economy

Structural VECM model

Ordering rationale

Assume that the exchange rate bears the first impact of external, exogenous shocks such as a change in foreign prices or interest rates. Any shock to the exchange rate contemporaneously affects all other variables, but other variables do not affect it instantaneously

This is followed by the interest rate affecting output and thereby the domestic demand and price but not the exchange rate.

Similarly, the next variable, output, affects only the domestic price index contemporaneously while the domestic price index does not affect any variable instantaneously

The exchange rate can also have an immediate effect on prices via import prices. Thus, domestic prices are ordered last in the model, which contemporaneously respond to all shocks in the system

Endogenous vars

IIP, WPI, NER, 91-day TBill rate

Exogenous vars

US PPI, 3-month TBill rate of US Fed

All the variables, except the interest rate, are in logs. Interest rate is nonstationary and one cointegrating relation at 1 % significance level

“Implications of bank ownership for the credit channel of monetary policy transmission: evidence from India”

Bank level annual data; 2000 to 2007

Question looked at

How bank ownership plays a role in the credit channel of monetary policy transmission; whether the reaction of different types of banks (i.e., private, state and foreign) to monetary policy changes is different in easy and tight policy regimes

Estimates the change in loans in response to changes in PLR at the bank level

Bank lending channel to be working much more effectively in a tight money period than in an easy money period in India, i.e., banks decrease loan supply in response to increases in PLR in tight money periods

Considerable differences in the reactions to monetary policy initiatives of various banks differentiated by ownership pattern

These reactions are also influenced by the surplus or deficit liquidity conditions, with bank lending channel of monetary policy transmission being more effective under deficit condition than under surplus condition.

(Not giving much details since it is a different research design)

Since the authors use the prime lending rate of banks themselves as the indicator of monetary policy, however, they implicitly assume complete and quick pass-through of changes in monetary policy to bank lending rates, thus missing a potential price response by banks to monetary policy and looking only for a quantity response

A contractionary monetary policy shock is associated with a statistically significant reduction in real output, but monetary policy shocks accounted for a small part of the forecast error variance in real output (Not giving details as not a conventional MP transmission paper)

Two policy instruments considered are CRR and change in Bank Rate (because their medium-term impact on bank lending can be expected to be direct and fairly quick).

Bank balance sheet data: Loans advanced by commercial banks, funds (defined as the aggregate of deposits and borrowings) with commercial banks and commercial banks’ investments in government securities—all in logs

Shock to CRR

With an increase in CRR, money supply (LM3) decreases, the market-determined interest rate (CPR) rises and increases for 5 months before the onset of a decline in its growth rate

With a rise in CRR, the price variable initially increases in the first month but starts declining after the second month forming a hump-shaped figure

As a result of increasing CRR, output (LIIP) declines

Shock to Bank Rate

The money supply decreases and the price variable, after registering an initial drop, increases till the tenth month. There is inconsistency in the behavior of output and market-determined interest rate. IIP shows practically no effect

They also see the effect of monetary tightening (using both CRR and bank rate) on log NEER, net FII inflows, FX reserves, Trade Balance, and BSE market cap

A fall in CRR is accompanied by a rise in bank credit. There is a shift upwards in the economic activity parameter immediately given by log IIP

Summary

1. On the basis of variance decompositions, there is not much difference as between CRR and bank rate as alternative policy instruments. However, on the basis of plausibility of relationships as given by the impulse response functions, CRR seems to perform relatively better vis-à-vis the Bank Rate

2. The response of advances to a change in the policy variable turns out to be significant at conventional levels, irrespective of whether the price variable (Bank Rate) or the quantity variable (CRR) is considered i.e., banks tend to cut back lending and adjust their funds in response to a policy action

3. Primarily the public sector banks are more reactive to the policy shocks